In recent weeks the national news media has been abuzz with articles regarding the Federal Trade Commission’s proposed new ban on noncompete clauses in the workplace, including a New York Times Op-Ed written by the FTC’s chair.[1] While they may take various forms, oftentimes noncompete clauses are used by employers to restrain departing employees from taking their services to a competitor.[2]

For well over a century, states throughout the U.S. have grappled with the issue of whether, when and under what circumstances an employer may utilize a noncompete clause to restrain employment options of a departing employee. Unsurprisingly within our fifty states, markedly different conclusions have been reached by state legislatures and state courts about the legality of non-compete agreements.

For example, under California law, since the early 19th century every contract that restrains anyone from engaging in a profession, trade, or business is void.[3] In a landmark California Supreme Court decision[4], the Court upheld the ban on noncompete clauses unless such agreements fell within narrow statutory exceptions.[5] Indeed, even non-compete clauses that only narrowly restrain employees from engaging in their profession, trade, or business may be unenforceable, with employer claims of “reasonableness” irrelevant.[6] Following the Edwards v. Arthur Andersen LLP decision, as a general rule a California employee would only be bound by a non-solicitation agreement if it was designed to protect a company’s trade secrets or other intellectual property.

In contrast, New York law holds that non-compete clauses in employment agreements are enforceable so long as they are reasonable.[7] A non-compete clause is reasonable only if it (1) is no greater than is required for the protection of the legitimate interest of the employer, (2) does not impose undue hardship on the employee, and (3) is not injurious to the public.[8] New York law recognizes the following as an employer’s legitimate interests: protecting trade secrets, protecting competition from a former employee “whose services are unique or extraordinary”, and preventing past employees from exploiting or appropriating a client or customer’s goodwill.[9]

Delaware law also holds that non-compete clauses in employment contracts are enforceable to protect employers from sustaining damages caused by a previous employee’s competition.[10] Applying contract principles, a non-compete clause is enforceable if the employer and the employee mutually assent to the terms of the agreement and the agreement is supported by a bargained-for exchange.[11]

States line up on all ends of this spectrum, and the recent FTC activity foreshadows a potential sea-change in the law surrounding non-competes with federal law preempting the field.

Early in the Biden Administration, an executive order directed the entirety of the federal government to prioritize work involving competition policy and enforcement in the labor markets.[12] While cast in terms of broad worker protection that would improve worker mobility involving low-wage earners including hourly food service workers who may be bound by restrictive non-competes, the proposed FTC rulemaking appears to not distinguish between low-paid hourly workers versus highly paid executives or key management in large companies or even start-ups.

The proposed FTC rule unveiled early this year designates non-compete clauses and functional non-compete clauses as an unfair method of competition.[13] Practices that are designated unfair methods of competition are unlawful and prohibited.[14] The FTC defines a non-compete clause as “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.”[15] On the other hand, the FTC defines a functional non-compete clause as “a contractual term that is a de facto non-compete clause” because it has the same effect of a non-compete.[16] The FTC offers two (non-exhaustive) examples of a functional non-compete:

1. A non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer.[17]

2. A contractual term between an employer and a worker that requires the worker to pay the employer or a third-party entity for training costs if the worker’s employment terminates within a specified time period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.[17]

The proposed rule also requires a retroactive rescission of non-competes entered into before the proposed rule becomes effective, subject to a notice requirement.[19] In effect, the employer must give its employees notice that the non-compete is no longer in effect and is unenforceable.[20]

This proposed FTC rule would have the effect of federalizing the field of non-compete agreements and, if adopted, would have broad implications throughout the U.S. economy, including in the start-up and VC world.

Noncompete Clauses from the Venture Capital Perspective

Investors and founders of new businesses are concerned about protecting the IP rights and know-how of the start-ups, which may be the core value of the businesses. Oftentimes, investors will require their portfolio companies to sign agreements with founders and key employees that include noncompete clauses of various stripes that restrict the founders or key employees who have the technical skills and created the IP of such portfolio companies from working for their competitors. These provisions are elaborated restrictions imposed by the investors, prohibiting the founders or key employees from carrying on any similar or identical businesses to that of the portfolio companies once they cease to be a shareholder or an employee of such portfolio companies for a certain duration of time thereafter. An issue is whether such non-compete provisions are enforceable against founders or key employees, who may be serial entrepreneurs and usually form more companies doing the identical or similar business(es).

In certain states such as California that are less receptive to noncompete agreements, counsel for investors and companies have developed alternative ways to protect the relevant IP. In practice, the most common ways have been by asking the founders and key employees to sign carefully tailored and narrowly drawn nondisclosure agreements, non-solicitation agreements and confidential information and invention assignment agreements when they join the company, oftentimes coupled with linking whatever equity may have been provided by that founder/key employee (discussed below).

Nondisclosure Agreement

In some industries, trade secrets are at the core of a business’ value. These businesses often maintain valuable and confidential information, such as a secret invention design, a specific idea for a new method of service that is web-based, confidential material contained in a copyrighted software program, a sales plan, a compiled list of customers, a manufacturing process, or a formula for a product – basically, any information that is not generally known, safeguarded by the owners and gives the business a competitive advantage in the marketplace may be considered “trade secrets.” One of the risks that businesses face is that employees may take trade secrets they learn on the job and leave for a competitor company.

Nondisclosure agreements (“NDAs”) are one of the most effective ways to prevent such employee from disclosing the trade secrets to anyone either during or after his or her employment as long as such trade secrets remain non-public. An NDA is a contract in which the employee agrees to protect the confidentiality of trade secret disclosed to him or her during employment. By using an NDA, an employer can ensure that its trade secrets stay secret by giving the company legal recourse against an employee who wrongfully discloses them.

When enforcing a breach of an NDA, oftentimes a company will demonstrate that it has put in efforts to protect its business’ trade secret. A company may demonstrate that it took all the necessary precautions by, for example, demonstrating that it uses software in its company that provides digital security.

Non-solicitation Clause/Agreement

A non-solicit clause (i.e., a restrictive covenant in an investment agreement or a non-solicitation agreement), would likely comport with Edwards v. Arthur Andersen LLP because such a clause does not restrain a departing employee from engaging in a competing business, trade, or profession. A non-solicit clause limits the ability of the founder or key employee to communicate and conduct business with the clients, employees, or suppliers of the company for a specific period of time.

To illustrate, after leaving the company, the founder or key employee may engage in the solicitation of the suppliers, customers, or employees of the company, thereby diverting its resources and draining its intellectual and operational capacity. When companies lose talented employees or trusted key suppliers, such losses directly impact their performance, operations, credibility, and positions in the market. In order to protect the investments and their market values of the portfolio companies, investors seek to insert a non-solicit clause in their investment agreements or ask founders or key employees to sign separate non-solicitation agreements, to ensure that the founders or key employees do not set up competing businesses or engage with the suppliers, employees, or clients of the investee company after their departure.

Confidential Information and Invention Assignment Agreement

Founding a technology-based company is almost always accompanied by the continued development and brainstorming surrounding the source IP. Naturally the co-founders and their outside service providers (coders, vendors, etc.) may have access to all kinds of proprietary information and IP of the company. Co-founders may have rights to use the IP, independent of their association with the company. Hence, it is important to every company to have its founders and key employees sign a confidential information and invention assignment agreement (“CIIAA”) at the early stage. A CIIAA will protect the company’s IP rights by having the founders and key employees assign all the work product and the related IP rights to the company. The CIIAA will protect the company’s IP rights such that when co-founders or key employees leave the company, they cannot take the IP rights with them.

In addition, by attempting to define with particularity what “confidential information” means in a particular circumstance, the company may better protect its IP rights by prohibiting the founders and key employees from disclosing confidential information to anybody, thereby limiting their capacity in assisting the competing businesses.

Vesting of Company Stock/Options

The inclusion of a vesting schedule of a company’s stock and options granted to a key employee in his or her employment contract is not a direct way of restricting a key employee’s future employment to not compete with the company. However, a vesting schedule may be a fairly effective way to retain talented people and to dissuade them from leaving the company.

A Specific Exception Applicable to Non-Compete Clauses

Where a founder is selling all of[21] his or her business and goodwill to a buyer, a covenant of non-competition or some degree of restrictions on the founder’s ability to form or operate other identical or similar businesses will be enforceable. This exception is usually known as the “sale of business” exception, and is also commonly applied to circumstances where a person (whether or not that person is a founder) is selling all of his or her ownership stake in a business. The rationale behind this exception is to protect a buyer’s interest in enjoying the IP and goodwill it purchased with a consideration free from competition by the seller.

Conclusion

The FTC’s proposed rule practically extends California’s prohibition of noncompete clause to all other states, including those states that currently allow noncompete clauses. If adopted, the FTC’s proposed rule would likely make more difficult efforts by companies to strategically provide for “choice of law” clauses that select states that may be more hospitable to the use of noncompete and similar clauses.[22] If adopted, counsel for investors and companies will need to explore more strategies to protect their company’s IP rights, knowhow and goodwill to ensure that the value of the business is not at risk if a key-employee departs.

[1] See Lina M. Khan, Lina Khan: Noncompetes Depress Wages and Kill Innovation, N.Y. Times, (Jan. 9, 2023), https://www.nytimes.com/2023/01/09/opinion/linakhan-ftc-noncompete.html; Eugene Scalia, The FTC’s Breathtaking Power Grab Over Noncompete Agreements, WSJ (Jan. 12, 2023, 6:50 pm), https://www.wsj.com/articles/the-ftcs-breathtaking-power-grab-noncompete-agreements-rule-capital-investment-wage-gap-job-growth-compliance-11673546029?mod=Searchresults_pos8&page=1.

[2] See, e.g., California Business & Professions Code § 16600.

[3] See id.

[4] Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008).

[5] Id. at 942.

[6] Id. at 948-950.

[7] BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 388 (1999).

[8] Id. at 388-389.

[9] Arthur J. Gallagher & Co. v. Marchese, 946 N.Y.S.2d 243, 244 (2012).

[10] Faw, Casson & Co. v. Cranston, 375 A.2d 463, 465 (1977).

[11] Id. at 466.

[12] Exec. Order No. 14036, 86 FR 36987 (2021).

[13] Notice of Proposed Rulemaking, Federal Trade Comm’n, at p. 213 (Jan. 5, 2023) (to be codified at 16 C.F.R. § 910).

[14] 15 U.S.C.A. § 45(a)(1).

[15] Notice of Proposed Rulemaking at p. 211 (§ 910.1(b)(1)).

[16] Id. at p. 212 (§ 910.1(b)(2)).

[17] Id. at p. 212 (§ 910.1(b)(2)(i)).

[18] Id. at p. 212 (§ 910.1(b)(2)(ii)).

[19] Id. at 213 (§ 910.2(a)).

[20] Id. at 213 (§ 910.2(b)(1)).

[21] See, e.g., California Business & Professions Code § 16600 and § 16601.

[22] See, e.g., California Labor Code §925, which provides that an employer cannot require an employee who primarily resides and works in California, as a condition of employment, to agree to adjudicate a claim arising in California outside of California. Yet there are exceptions to §925 the net effect of which may under certain circumstances permit the enforcement of non-California choice of law agreements.